Blip, bubble, burst

Recent turmoil in global equity markets suggests something is happening, but what? Richard Willsher investigates

In late February the Chinese stock market took a sharp, one-day dive. This set off a series of tumbles in major stock markets around the globe. The FTSE100 fell back by almost 2.5% and the Dow by almost 3.5%. It did not stop there. For several days the international markets had the jitters and continued on a downward path. Was this the start of a major equity market downturn after a long-lasting bull run? Or was it merely a blip, a temporary interruption after which normal index appreciation would resume? Or, then again, was it the first tremor stemming from something deeper and more fundamental beneath the surface of the global economy?

Looking at the trend lines of the world markets, it now seems to have been a mild aberration. Nothing as strong or as potentially cataclysmic as the 'market adjustment' of May 2006. And index watchers and stock price commentators can often be accused of market myopia of the type criticised by the veteran world's greatest investor, Warren Buffett, who has always advocated the long view. But then it all depends where you start to draw your trend line or when you bought your stock.

'Markets are always vulnerable to major corrections,' comments Mike Lenhoff, chief strategist at Brewin Dolphin Securities, a UK stockbroker and the country's largest independent investment manager. 'And this one occurred very rapidly. It reminded me of the one we saw last May, which was more serious and lasted much longer. But the rebound we saw from that volatility took the market to new highs.' He is generally upbeat about the buying opportunities that market corrections bring about, but sees markets continuing to be vulnerable, especially in the light of rising interest rates in Europe, including the UK, and in the US, and the drop in the earnings of major corporates after a four-year period of strong earnings growth.

Both of these point towards broader economic performance and factors beyond the immediate sphere of stock market influence. It is some of these issues that could drive a blip to become a more serious burst bubble or trigger a recession, particularly in the US.

For example, rising interest rates in the US have contributed to a severe crisis among those most at risk from over-borrowing. The result: more than 40 lenders, in particular mortgage lenders, to the sub-prime sector have collapsed or filed for Chapter 11 protection from their creditors. The number of personal bankruptcies has shot up. The same is true in the UK where the number of individual voluntary arrangements (with personal creditors) and small business bankruptcies has burgeoned. Unsurprisingly, a number of accounting firms are building up their insolvency practices, while corporate finance houses are gearing up their restructuring teams.

Research by Close Brothers, a leading City corporate finance house with a strong restructuring advisory business, shows that many corporates across Europe are very highly leveraged and that a great deal of this debt is poorly rated, meaning that the probability of default was relatively high to begin with. Andrew Merrett, a director of the European special situations group at Close, says: 'There is a huge escalation in the amount of debt companies are carrying. Many of these loans are equity by another name, and have been made to borrowers of poorer credit quality. This in itself will cause default rates to rise whatever happens in the wider economy. But, with the upward pressure on interest rates, these structures will be severely tested. And there's going to be fall-out.'

A similar fall-out looks probable in the private equity industry where, increasingly, higher earnings multiples are being shelled out for business acquired by private equity funds. But, significantly, these deals have also been fuelled by high proportions of debt to equity. There are now concerns among regulators, both in the US and at the UK's Financial Services Authority (FSA), that the failure of a major private equity deal is now 'inevitable'. This, the FSA believes, may pose a risk to the banking system, and in November 2006 it published Private Equity: A Discussion of Risk and Regulatory Engagement, listing no less than six reasons why it fears that private equity now poses a significant threat.

Another series of significant events in the private equity sector may be about to occur. Some of the world's major firms, including Blackstone, Kohlberg Kravis Roberts and the Carlyle Group, among others, are believed to be considering public listings, a sign that may be interpreted as the smart money cashing out at the top of both the private equity boom and the stock market upswing.

Soaring commodity prices may also be ripe for fall. Though when this is likely to occur is uncertain, as commodities analysts speak of a supercycle in certain commodity markets which tends not to correlate with stock market cycles. However, falls in commodity prices would be likely to aid corporates and national economic indicators. In addition, there are some other factors which may work against the risks of downturn too, according to Lenhoff. 'The good news is that you've got valuations in equity markets that are still very favourable... it is not as if equity markets are overvalued... they are still attractively valued. Secondly, you've got a lot of corporate activity, a lot of mergers and acquisitions and that has been a very supportive feature behind the strength of equity markets and, indeed, their recovery from that sell-off that we saw at the end of February.' He adds that both of these factors could be negated by a global recession, however.

Faltering demand

Meanwhile, the US economy is slowing down and massive amounts of debt are fuelling consumer spending, while the US personal savings rate has fallen significantly. Over the last several years it has been US consumers who have driven demand in the US, which is now faltering. However, the Federal Reserve chairman, Ben Bernanke, expressed confidence at the end of February when he said: 'My view is that, taking all the new data into account, there is really no material change in our expectations for the US economy... we are looking for moderate growth in the US economy going forward'. Remarks by his predecessor, Alan Greenspan, that recession in the US was 'possible' appeared to counter this view. A 1 March report from economists at the Royal Bank of Scotland (RBS), entitled Understanding Recent Market Turbulence, commented 'it is still early days and further volatility is possible given the potential for downside surprises in upcoming US data releases'.

What effect all this will have on investors' confidence over the longer term, say through the rest of this year, remains to be seen. The RBS report says that investors may become more risk-averse and this will tend to cause falls in equity markets, especially while interest rates are high. Other economists, notably at US financial services group Wachovia and the London-based Schroder Investment Management, have predicted that the US will have a soft landing in 2007 as interest rate reductions cushion the slowdown. Meanwhile, there is one factor above all others that may support markets going forward and that is cash. There are still massive amounts of cash from wholesale investors, from corporates and from the central banks of the Far Eastern economies. At the very least this cash needs a home and, as long as the pressure to invest it exists, the financial markets will be the beneficiaries, whether in equities or, more likely, highly-rated fixed income instruments. This wall of money on its own may act as a substitute for ebbing confidence, at least in the shorter term.

Richard Willsher is a financial and business writer with a background in investment banking.